Financial Simulation Modeling in Excel

OTHER METHODS TO DEVELOP DEFAULT PROBABILITIES

While structural models have a rich academic heritage and have been used for a generation by academics, practitioners have often looked to other techniques to assess credit. In general, risk managers are asked to assess a wide variety of assets, including non-public companies and municipal or sovereign bonds. Often, non-simulation-based techniques such as credit scoring are used and then are placed into a simulation framework using external default and correlation assumptions. However, there are also credit analysis techniques that depend on market information and are well suited for simulation.

The most common quantitative credit alternatives to the structural models already discussed are credit scoring and reduced form models. We will discuss credit scoring in the context of how credit scores are used in reduced-form models. Reduced form models are in many respects an extension of structural models, but they require less data in order to construct. However, there are downsides to the simplicity offered by reduced form models.

Robert Jarrow, one of the original developers of reduced form models as they are currently used, had this to say about reduced form models in a 2004 paper:

Structural models assume that the modeler has the same information set as the firm's manager—complete knowledge of all the firm's assets and liabilities. In most situations, this knowledge leads to a predictable default time. In contrast, reduced form models ...